AlistairBarr

The Hennessee Hedge Fund Index climbed 8% in 2005, beating U.S. equity market benchmarks such as the Standard & Poor's 500 and the Nasdaq Composite, which returned 4.9% and 1.4%, respectively, Hennessee reported. The Lehman Brothers Intermediate Government Corporate Bond Index, a fixed-income benchmark, climbed 1.6% in 2005.

In 2004, the Hennessee index, which tracks more than 900 managers, gained 8.3%, but lagged behind both the S&P 500 and the Nasdaq.

Outperformance in 2005 was driven mainly by international managers. Overseas and emerging-market hedge funds performed the best, with managers focused on the Asian-Pacific region, Latin America and Europe returning 19.9%, 19.7% and 16% respectively, Hennessee added.

Interest-rate increases by the Federal Reserve last year sucked liquidity out of stock markets and left investors relying more on research for gains. That favored equity hedge funds, said Lee Hennessee, managing principal partner of Hennessee Group.

"The Fed has orchestrated the most effective withdrawal of monetary stimulus since the 1980's," she said. "Equity hedge funds benefited from this as stock research ruled over liquidity driven equity markets for the first time in several years."

Hedge funds using arbitrage - exploiting discrepancies in the prices of related securities - didn't fare as well since equity markets weren't exceedingly volatile in 2005.

Convertible-arbitrage hedge funds, which trade convertible bonds, were the only strategy to lose money in 2005, shedding 2.2%, according to Hennessee's measurements.

"With a flat yield curve, low volatility, and tight credit spreads, arbitrage managers did not have much to work with," said Charles Gradante, also a managing principal of Hennessee Group. "Many arbitrageurs believe inflation is more likely to surprise on the downside in the coming months."

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